(Adds details, analyst comments, updates markets)
* Producer price index rises 0.4 percent in October
* PPI increases 2.8 percent year-on-year
* Core PPI gains 0.2 percent, up 2.3 percent year-on-year
WASHINGTON, Nov 14 (Reuters) - U.S. producer prices rose more than expected in October, driven by a surge in the cost of services, leading to the biggest annual increase in wholesale inflation in more than 5-1/2 years.
Tuesday's report from the Labor Department also showed steady gains in underlying producer prices, which supported expectations of a gradual increase in inflation and keep the Federal Reserve on track to raise interest rates in December.
"Reports that inflation is dead or too low are not true in every corner of the economy," said Chris Rupkey, chief economist at MUFG in New York. "It won't be long before producers will be faced with having to raise the prices of consumer goods if inflation continues to percolate here."
The producer price index for final demand increased 0.4 percent last month after a similar gain in September. That lifted the year-on-year increase in the PPI to 2.8 percent, the largest rise since February 2012, from 2.6 percent in September.
Economists had forecast the PPI edging up 0.1 percent last month and increasing 2.4 percent from a year ago. Last month's rise in prices received by the nation's farms, factories and refineries reflected a 0.5 percent surge in the cost of services, mostly margins received by wholesalers and retailers.
Margins for fuels and lubricants retailing soared 24.9 percent, accounting for almost half of the increase in the cost of services last month. Services rose 0.4 percent in September.
The rise in services helped to offset a 4.6 percent drop in the cost of gasoline. Wholesale gasoline prices spiked 10.9 percent in September in the aftermath of Hurricane Harvey, which struck Texas in late August and reduced refining capacity in the Gulf Coast area.
Gasoline prices are falling amid ample crude oil supplies. The strong producer price readings probably did not translate into higher consumer prices in October as the correlation between the PPI and consumer price index has weakened.
Still, firming inflation at the factory gate is likely to be welcomed by Fed officials who have long argued that price pressures were being held back by transitory factors.
The personal consumption expenditures (PCE) price index excluding food and energy inflation measure tracked by the Fed has remained below the U.S. central bank's 2 percent target since mid-2012.
Despite moderate price pressures, the Fed is expected to raise interest rates next month amid cautious optimism that tightening labor market conditions will spur faster wage growth next year. The Fed has hiked rates twice this year.
"While not the primary measure of inflation, the consistent gradual improvement in producer prices over the past two years will be welcomed by Fed officials who, on balance, continue to express confidence in a gradually rising inflation outlook," said Sam Bullard, a senior economist at Wells Fargo Securities in Charlotte, North Carolina.
MARGINAL CPI GAINS EXPECTED
Prices for U.S. Treasuries rose, with traders awaiting October's consumer inflation data on Wednesday, which is expected to show a marginal increase in consumer prices. The dollar fell against a basket of currencies. U.S. stocks slipped as declining oil prices hit energy stocks.
Outside services, producer price increases were fairly broad last month. There were increases in the cost of pharmaceutical preparations, fresh and dry vegetables, meat and tobacco. Prices for passenger cars were, however, unchanged in October following the introduction of the 2018 models into the survey.
A key gauge of underlying producer price pressures that excludes food, energy and trade services rose 0.2 percent in October month, advancing by the same margin for three straight months. The so-called core PPI increased 2.3 percent in the 12 months through October after advancing 2.1 percent in September.
Core goods prices increased 0.3 percent in October after a similar gain in the prior month. The weakening dollar, which has this year lost 5.4 percent of its value against the currencies of the United States' main trading partners, could gradually lift core producer inflation.
The cost of healthcare services increased 0.3 percent in October after being unchanged in September. Those costs feed into the core PCE price index. (Reporting By Lucia Mutikani; Editing by Andrea Ricci)